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Sm04 - Chapter solutions
Portfolio Analysis (University of Wollongong)
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CHAPTER 4
ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS
Answers to Questions
1.
A market is a means whereby buyers and sellers are brought together to aid in the transfer
of goods and/or services. While it generally has a physical location it need not necessarily
have one. Secondly, there is no requirement of ownership by those who establish and
administer the market - they need only provide a cheap, smooth transfer of goods and/or
services for a diverse clientele.
A good market should provide accurate information on the price and volume of past
transactions, and current supply and demand. Clearly, there should be rapid dissemination
of this information. Adequate liquidity is desirable so that participants may buy and sell
their goods and/or services rapidly, at a price reflecting the supply and demand. The costs
of transferring ownership and middleman commissions should be low. Finally, the
prevailing price should reflect all available information.
2.
This is a good discussion question for class because you could explore with students what
are some of the alternatives that are used by investors with regards to other assets such as
art and antiques. Some possibilities are ads in the paper of your local community or large
cities. Another obvious alternative is an auction. With an ad you would have to specify a
price or be ready to negotiate with a buyer. With an auction you would be very uncertain
of what you would receive. In all cases, there would be a substantial time problem.
3.
Liquidity is the ability to sell an asset quickly at a price not substantially different from
the current market assuming no new information is available. A share of AT&T is very
liquid, while an antique would be a fairly illiquid asset. A share of AT&T is highly liquid
since an investor could convert it into cash within 1/8 of a point (or less) of the current
market price. An antique is illiquid since it is relatively difficult to find a buyer and then
you are uncertain as to what price the prospective buyer would offer.
4.
The primary market in securities is where new issues are sold by corporations to acquire
new capital via the sale of bonds, preferred stock or common stock. The sale typically
takes place through an investment banker.
The secondary market is simply trading in outstanding securities. It involves transactions
between owners after the issue has been sold to the public by the company.
Consequently, the proceeds from the sale do not go to the company, as is the case with a
primary offering. Thus, the price of the security is important to the buyer and seller.
The functioning of the primary market would be seriously hampered in the absence of a
good secondary market. A good secondary market provides liquidity to an investor if he
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or she wants to alter the composition of his or her portfolio from securities to other assets
(i.e., house, etc.). Thus, investors would be reluctant to acquire securities in the primary
market if they felt they would not subsequently have the ability to sell the securities
quickly at a known price.
5.
An example of an initial public offering (IPO) would be a small company selling
company stock to the public for the first time. By contrast, a seasoned equity refers to an
established company, such as IBM, offering a new issue of common stock to an existing
market for the stock. The IPO involves greater risk for the buyer because there is not an
established secondary market for the small firm. Without an established secondary market
the buyer incurs additional liquidity risk associated with the IPO.
6.
Student Exercise
7.
In competitive bid the issuer is responsible for specifying the type of security to be
offered, the timing, etc. and then soliciting competitive bids from investment banking
firms wishing to act as an underwriter. The high bids will be awarded the contracts.
Negotiated relationships are contractual arrangements between an underwriter and the
issuer wherein the underwriter helps the issuer prepare the bond issue with the
understanding that they have the exclusive right to sell the issue.
8.
The three main factors that would account for the changes in the price of a seat on the
New York Stock Exchange are the relative stature of the NYSE, the large trading volume
relative to other exchanges and the general performance of the stock market.
9.
One reason for the existence of regional exchanges is that they provide trading facilities
for geographically local companies that do not qualify for listing on a national exchange.
Second, they list national firms thus providing small local brokerage firms that are not
members of a national exchange the opportunity to trade in securities that are listed on a
national exchange.
The essential difference between the national and regional exchanges is that the regional
exchanges have less stringent listing requirements, thus allowing small firms to obtain
listing.
10.
The OTC market is larger than the listed exchanges in terms of the number of issues
traded, almost 7,000 issues are traded on the OTC market compared to 3,200 stock issues
(common and preferred) for the NYSE. In sharp contrast, the NYSE has a larger total
value of trading - in 2000, NYSE value of equity trading was about $11,200 billion and
NASDAQ was about $7,400 billion.
11.
Level 1 provides a current quote on NASDAQ stocks for brokerage firms that are not
regular OTC customers. It is a median quote that is representative of the quotes of the
several market makers in the particular security. Level 2 is for serious traders who desire
not only current trends but also specific quotes of different market makers. This enables
the broker to make a deal with the market maker offering the best price. Level 3 is for
investment firms who desire all the information provided in Level 2 but also need the
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ability to enter their own quotes or change them relative to other market makers.
NASDAQ is an electronic quotation system that serves the OTC market. It enables all
quotes by all market makers to be immediately available.
12(a). The third market is the OTC trading of exchange-listed securities. It enables the nonmembers of the exchange to trade in exchange listed securities. Most of the large
institutional favorites are traded on the third market - e.g., IBM, Xerox, General Motors.
12(b). The fourth market is the direct trading between two parties without a broker intermediary.
Institutions trade in the fourth market since these trades are large volume and
consequently substantial savings can be made by trading directly with a buyer, thus
avoiding commissions.
13(a). A market order is an order to buy/sell a stock at the most profitable ask/bid prices
prevailing at the time the order hits the exchange floor. A market order implies the
investor wants the transaction completed quickly at the prevailing price. Example: I read
good reports about AT&T and I’m certain the stock will go up in value. When I call my
broker and submit a market buy order for 100 shares of AT&T, the prevailing asking price
is 60. Total cost for my shares will be $6,000 + commission.
13(b). A limit order specifies a maximum price that the individual will pay to purchase the stock
or the minimum he will accept to sell it. Example: AT&T is selling for $60 - I would put
in a limit buy order for one week to buy 100 shares at $59.
13(c). A short sale is the sale of stock that is not currently owned by the seller with the intent of
purchasing it later at a lower price. This is done by borrowing the stock from another
investor through a broker. Example: I expect AT&T to go to $48 - I would sell it short at
$60 and expect to replace it when it gets to $55.
13(d). A stop-loss order is a conditional order whereby the investor indicates that he wants to
sell the stock if the price drops to a specified price, thus protecting himself from a large
and rapid decline in price. Example: I buy AT&T at $60 and put in a stop loss at $57 that
protects me from a major loss if it starts to decline.
14.
The specialist acts as a broker in handling limit orders placed with member brokers.
Being constantly in touch with current prices, he is in a better position to execute limit
orders since it is entered in his books and executed as soon as appropriate. Second, he
maintains a fair and orderly market by trading on his own account when there is
inadequate supply or demand. If the spread between the bid and ask is substantial, he can
place his own bid or ask in order to narrow the spread. This helps provide a continuous
market with orderly price changes.
The specialist obtains income from both his functions: commissions as a broker, and
outperforming the market in his dealer function using the monopolistic information he
has on limit orders.
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15.
The Saitori members are referred to as intermediary clerks. Similar to the U.S. specialists,
the Saitori members do not deal with public customers. Their duties entail matching buy
and sell orders for the regular members of the Tokyo Exchange and they maintain the
book for regular limit orders. Unlike the U.S. exchange specialist, the Saitori are not
allowed to buy and sell for their own account and, thus, they do not have the duty or
capability to ensure an orderly market.
16.
Much of the change experienced on the secondary equity market can be attributed to
changes occurring within the financial industry as a whole. As banks, insurance
companies, investment companies and other financial service firms enter the capital
markets, the volume and size of transactions continue to grow. This dominance by large
institutions in the marketplace caused the following changes in the markets:
(1) the imposition of negotiated (competitive) commission rates
(2) the influence of block trades
(3) the impact of stock price volatility
(4) the development of a national market system
These changes have increased the competition among firms that trade large institutional
stocks. However, there is some concern that the individual investor is being “crowded
out” and that the equity market for smaller firms will also suffer. The evolving
globalization of markets will also have an impact.
17.
A “give-up” is the practice of the brokerage firm executing the trade paying part of the
commission to other brokerage or research firms designated by the institution. Typically,
these other brokerage firms provided research or sales services to the institution. These
commission transfers were referred to as “soft dollars.” “Give-ups” existed in the fixed
commission world because brokers realized that institutions were charged more for large
trades than justified by the cost.
18.
A block house is a brokerage firm, either member or non-member of an exchange, which
stands ready to buy or sell a block for institutions. Block houses evolved because
institutions were not getting what they needed from the specialist and, hence, asked
institutional brokerage firms to locate other institutions with an interest in buying or
selling given blocks.
When an institution wishes to sell a stock it typically contacts a block house, who
contacts prospective institutional buyers. If the block house does not find buyers for the
entire block, it buys the remainder (thus taking a position) with the hope of selling it later.
Naturally, the block house assumes substantial risk on this position because of the
uncertainty of subsequent price changes.
19(a). Though the exact form of the National Market System (NMS) remains nebulous, major
features of such a market are:
(1) Centralized reporting of all transactions regardless of where the trade took place.
Currently, this exists for all NYSE stocks.
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(2)
(3)
(4)
Centralized quotation system that would list quotes for a given stock from all
market-makers on the national exchanges, the regional exchanges, and the OTC.
This increased information is beneficial to the investor.
Central limit order book (CLOB) that contains all limit orders from all
exchanges.
Competition among market-makers which would force dealers to offer better
bids and asks, thus narrowing the bid-ask spread.
19(b). The Inter-Market Trading System (ITS) is a centralized quotation system, currently
available, consisting of a central computer facility with interconnected terminals in the
participating market centers. Brokers and market-makers in each market center can
indicate to those in other centers specific buying and selling commitments by way of a
composite quotation display. A broker or market-maker in any market center can thus
exercise his own best judgment in determining, on the basis of current quotations, where
to execute a customer’s orders. While ITS provides the centralized quotation system that
is necessary for a National Market System (NMS), it does not have the capability for
automatic execution at the best market; it is necessary to contact the market-maker and
indicate that you want to buy or sell at his bid or ask. Also, it is not mandatory that a
broker go to the best market to execute a customer’s orders.
The data in Exhibit 4.13 indicate significant growth in the number of issues on the system
through 1999, with a drop-off in 2000. The volume of shares traded and the size of the
trades continued to grow through 2000.
20.
Student Exercise
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CHAPTER 4
Answers to Problems
1(a).
Assume you pay cash for the stock: Number of shares you could purchase = $40,000/$80
= 500 shares.
(1)
If the stock is later sold at $100 a share, the total shares proceeds would be $100 x
500 shares = $50,000. Therefore, the rate of return from investing in the stock is
as follows:

(2)
$50,000  $40,000
25.00%
$40,000
If stock is later sold at $40 a share, the total shares proceeds would be $40 x $500
shares = $20,000. Therefore, the rate of return from investing in the stock would
be:

$20,000  $40,000
 50.00%
$40,000
1(b).
Assuming you use the maximum amount of leverage in buying the stock, the leverage
factor for a 60 percent margin requirement is = 1/percentage margin requirement = 1/.60
= 5/3. Thus, the rate of return on the stock if it is later sold at $100 a share = 25.00% x
5/3 = 41.67%. In contrast, the rate of return on the stock if it is sold for $40 a share:
= -50.00% x 5/3 = -83.33%.
2(a).
Since the margin is 40 percent and Lauren currently has $50,000 on deposit in her margin
account, if Lauren uses the maximum allowable margin her $50,000 deposit must
represent 40% of her total investment. Thus, $50,000 = .4x then x = $125,000. Since the
shares are priced at $35 each, Lauren can purchase $125,000 – $35 = 3,571 shares
(rounded).
2(b).
Total Profit = Total Return - Total Investment
(1)
If stock rises to $45/share, Lauren’s total return is:
3,571 shares x $45 = $160,695.
Total profit = $160,695 - $125,000 = $35,695
(2)
If stock falls to $25/share, Lauren’s total return is:
3,571 shares x $25 = $89,275.
Total loss = $89,275 - $125,000 = -$35,725.
2(c)
Margin 
Market Value - Debit Balance
Market Value
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where Market Value = Price per share x Number of shares.
Initial Loan Value = Total Investment - Initial Margin.
= $125,000 - $50,000 = $75,000
Therefore, if maintenance margin is 30 percent:
.30 
(3,571 shares x Price) - $75,000
(3,571 shares x Price
.30 (3,571 x Price)
1,071.3 x Price
-2,499.7 x Price
Price
3.
= (3,571 x Price) - $75,000.
= (3,571 x Price) - $75,000
= -$75,000
= $30.00
Profit = Ending Value - Beginning Value + Dividends - Transaction Costs - Interest
Beginning Value of Investment = $20 x 100 shares = $2,000
Your Investment = margin requirement + commission.
= (.55 x $2,000) + (.03 x $2,000)
= $1,100 + $60
= $1,160
Ending Value of Investment = $27 x 100 shares
= $2,700
Dividends = $.50 x 100 shares = $50.00
Transaction Costs = (.03 x $2,000) + (.03 x $2,700)
(Commission)
= $60 + $81
= $141
Interest = .10 x (.45 x $2,000) = $90.00
Therefore:
Profit = $2,700 - $2,000 + $50 - $141 - $90
= $519
The rate of return on your investment of $1,160 is:
$519/$1,160 = 44.74%
4.
Profit on a Short Sale = Begin.Value - Ending Value - Dividends -Trans. Costs - Interest
Beginning Value of Investment = $56.00 x 100 shares = $5,600
(sold under a short sale arrangement)
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Your investment = margin requirement + commission
= (.45 x $5,600) + $155
= $2,520 + $155
= $2,675
Ending Value of Investment = $45.00 x 100 = $4,500
(Cost of closing out position)
Dividends = $2.50 x 100 shares = $250.00
Transaction Costs = $155 + $145 = $300.00
Interest = .08 x (.55 x $5,600) = $246.40
Therefore:
Profit = $5,600 - $4,500 - $250 - $300 - $246.40
= $303.60
The rate of return on your investment of $2,675 is:
$303.60/$2,675 = 11.35%
5(a).
I am satisfied with the profit resulting from the sale of the 200 shares at $40.
5(b).
With the stop loss: ($40 - $25)/$25 = 60%
Without the stop loss: ($30 - $25)/$25 = 20%
6(a).
6(b).
Assuming that you pay cash for the stock:
Assuming that you used the maximum leverage in buying the stock, the leverage factor
($45 x 300) - ($30 x 300)
13,500 - 9000
Rate of Return 

50%
($30 x 300)
9000
for a 60 percent margin requirement is = 1/margin requirement = 1/.60 = 1.67. Thus, the
rate of return on the stock if it is later sold at $45 a share = 50% x 1.67 = 83.33%.
7.
Limit order @ $24: When market declined to $20, your limit order was executed $24
(buy), then the price went to $36.
Rate of return = ($36 - $24)/$24 = 50%.
Assuming market order @ $28: Buy at $28, price goes to $36
Rate of return = ($36 - $28)/$28 = 28.57%.
Limit order @ $18: Since the market did not decline to $18 (lowest price was $20) the
limit order was never executed.
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